Fixed, Indexed and Variable Annuities: How the Main Types Differ

Annuity sales materials can make every product sound unique, but most deferred annuities fall into a handful of types. Once you know which type you are looking at, you know the basic shape of its risks, its growth potential and the way it charges you.

The SEC's Investor.gov lists four main types of deferred annuities in order of increasing risk: fixed, fixed indexed, registered index-linked (RILA) and variable. It also notes that some contracts combine features of more than one type. This guide compares fixed, fixed indexed and variable annuities; RILAs have their own guide in this section because they work a little differently.

As with everything on this site, this is general information, not financial, insurance or tax advice.

Fixed annuities: a set rate from the insurer

A fixed annuity, according to Investor.gov, guarantees your money will earn at least a minimum interest rate during the accumulation phase. The insurer sets the rates and may pay more than the minimum, but only the minimum is guaranteed.

FINRA adds an important detail: the rate is often fixed for a number of years and then changes periodically based on current rates. That means a high first-year rate is not necessarily the rate you will earn for the life of the contract. The NAIC's consumer checklist makes the same point, urging buyers to understand the difference between the guaranteed minimum rate, the current rate and any first-year or "bonus" rate.

On risk, Investor.gov describes fixed annuities as the least risky of the four types, with the lowest potential return. Outside of surrender charges for early withdrawals, there is generally no potential to lose money, as long as the insurer can pay. Ongoing costs are usually not billed separately; Investor.gov says they are reflected in the interest rate.

The main risk with a fixed annuity is quieter: inflation. FINRA notes that fixed annuity payments typically don't have cost-of-living adjustments, so their purchasing power may decline over time.

Fixed indexed annuities: interest tied to an index, with a zero floor

A fixed indexed annuity, sometimes called an equity-indexed annuity, credits interest based in part on how a market index performs over a set term, often one year. Investor.gov explains that you don't know the interest rate in advance, but the credited rate is guaranteed never to be less than zero, even if the market goes down.

The catch is that you rarely receive the full index gain. The SEC's investor bulletin on indexed annuities describes several ways returns are limited:

• Dividends are usually excluded, so the index's return is measured without the dividends paid by the stocks in it.
• A participation rate credits only a share of the index's gain.
• A rate cap sets a maximum return for the period.
• A spread, margin or asset fee subtracts a set percentage from any gain.

The SEC bulletin notes that these features can reduce your return the same way a direct fee would, even on an annuity marketed as "no fee," and that insurers can often change some of them, such as the cap, from time to time. How each one works is covered in the Costs & Fine Print section of this site.

FINRA's 2022 article on indexed annuities says the guaranteed minimum interest rate on these products usually ranges from 1 to 3 percent on at least 87.5 percent of the premium paid. Under the NAIC's Standard Nonforfeiture Law for Individual Deferred Annuities (Model 805, as amended in Fall 2020), which states adopt in their own form, the minimum rate used for those guaranteed values is tied to a five-year Treasury rate and set no higher than 3 percent and no lower than 0.15 percent, so ask what your own contract guarantees. FINRA also notes that the variety of crediting methods makes it difficult to compare one indexed annuity to another.

On the risk spectrum, Investor.gov places fixed indexed annuities between fixed and variable: riskier than a fixed annuity, with more potential return.

Variable annuities: your money in a menu of funds

A variable annuity lets you direct your money into a menu of investment options during the accumulation phase, typically mutual funds, which FINRA says are called subaccounts. Investor.gov puts it plainly: there are no limits on losses or gains, and your return depends on how the funds you choose perform.

That makes variable annuities the riskiest of the four main types, with the highest potential return. They are also securities, so in addition to state insurance regulation they are registered with the SEC and come with a prospectus.

Variable annuities typically come with explicit fees, both under the contract and from the underlying funds. FINRA cautions that their annual expenses are likely to be much higher than those of a typical mutual fund. In return, they commonly include features that mutual funds don't, such as a death benefit, which Investor.gov says generally pays your beneficiary the greater of your account value or a guaranteed minimum, such as your purchase payments minus prior withdrawals, plus optional living and death benefits at an extra charge.

FINRA notes that, because of their complexity, variable annuities are a leading source of investor complaints to FINRA.

Side by side

Investor.gov publishes a comparison table for the four types. Here is how it describes three of them:

• Growth potential: a fixed annuity offers guaranteed growth at a fixed rate; a fixed indexed annuity offers growth tied to an index but with limits; a variable annuity's growth depends on the funds you select.
• Potential for loss: generally none for fixed and fixed indexed annuities, other than surrender charges during the surrender period; potentially unlimited for a variable annuity, plus surrender charges.
• Ongoing fees: reflected in the interest rate for fixed annuities; reflected in limits on earnings for fixed indexed annuities; explicit contract and fund fees for variable annuities.
• Who regulates: fixed and fixed indexed annuities are insurance products regulated by state insurance regulators; variable annuities are also securities registered with the SEC.
• Typical buyer: Investor.gov describes the fixed annuity buyer as having very low to low risk tolerance and seeking a guaranteed, set return; the fixed indexed buyer as having low risk tolerance and seeking moderate returns; and the variable annuity buyer as having moderate to very high risk tolerance and prioritizing growth over protection. All three share a long-term time horizon.

Matching the type to your goal

Instead of asking which annuity is "best," ask what job you need the money to do. For example, imagine a hypothetical retiree whose main worry is a guaranteed, predictable return on a portion of savings. The fixed annuity description is closest to that goal. Someone else who wants stock-market growth inside a tax-deferred contract and can accept losses is describing the variable annuity buyer. A fixed indexed annuity sits in between, trading some upside for protection against loss.

Whichever type you are offered, a few questions from Investor.gov apply to all of them:

1. Which type is this, and why does it fit my goals better than the others?
2. What fees, explicit or implicit, apply, and what limits are placed on my earnings?
3. How long must I hold it to avoid surrender charges, tax penalties and contract adjustments?
4. How exactly is interest or investment performance credited?
5. How strong is the insurer, and how does this fit my overall financial plan?

If a seller can't answer clearly, that is useful information too. For help that is specific to you, contact your state insurance department or a licensed financial professional, and check a securities seller on FINRA BrokerCheck.

Key takeaways

• Investor.gov ranks the main deferred annuity types from least to most risky: fixed, fixed indexed, RILA and variable.
• Fixed annuities guarantee a minimum rate set by the insurer; the current rate can change after an initial period.
• Fixed indexed annuities can't credit less than zero, but participation rates, caps, spreads and excluded dividends limit gains.
• Variable annuities invest in fund subaccounts with no limit on gains or losses and usually carry explicit fees.
• Pick the type based on the job the money needs to do, not on a headline rate.

Sources - U.S. Securities and Exchange Commission (Investor.gov), Annuities — https://www.investor.gov/introduction-investing/investing-basics/investment-products/annuities - U.S. Securities and Exchange Commission (Investor.gov), Updated Investor Bulletin: Indexed Annuities — https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-investor-bulletin-indexed-annuities - U.S. Securities and Exchange Commission (Investor.gov), Variable Annuities — https://www.investor.gov/introduction-investing/investing-basics/investment-products/annuities/variable-annuities - FINRA, Annuities — https://www.finra.org/investors/investing/investment-products/annuities - FINRA, The Complicated Risks and Rewards of Indexed Annuities — https://www.finra.org/investors/insights/complicated-risks-and-rewards-indexed-annuities - National Association of Insurance Commissioners, What You Should Know Before Buying an Annuity — https://content.naic.org/sites/default/files/consumer-what-to-know-before-buying-annuity.pdf - National Association of Insurance Commissioners, Standard Nonforfeiture Law for Individual Deferred Annuities (Model 805, Fall 2020) — https://content.naic.org/sites/default/files/model-law-805.pdf